Hedging

Hedging is insurance against the risks in the financial markets associated with fluctuations in the prices of a selected asset or group of assets.

Hedging can be associated not only with the risk of changes in the price of the selected asset, but also with other risks: counterparty risk, foreign exchange risk when trading assets in foreign currencies, risk of default of a broker on its obligations, and others.

Below, we will analyze how you can reduce the main risks in the financial markets today and also consider the approaches associated with hedging when developing a trading strategy.

The basic concept of hedging

By definition, the meaning of hedging in trading and finance is to minimize the risk of capital loss. The main risks for a trader have been discussed above. Let's consider the concept of managing them below.

➡️ How does hedging work? Generally speaking, hedging is not associated with specific risk but aims to preserve the trader's capital in the face of market volatility. Ideally, a trader creates a system of rules whose implementation helps to reduce each risk.

In this case, the answers may be:

1.           This risk is the probability of the broker's failure to meet his obligations, in which case the customer runs the risk of losing all or part of his deposit.

2.           The reasons may be (1) broker inefficiency, or (2) broker fraud.

3.           To minimize (1) the risk of market inefficiency, the following aspects can be considered: the number of years in the market and customer opinions. The number of years shows that the broker has been able to remain competitive over time, both in times of market growth and recession. Duration of more than 15 years can be considered trustworthy.

Customer reviews show their satisfaction with the company's service. Many brokers publish review statistics on their websites or in informational and educational articles.

✅ To minimize (2) the risk of fraud on the part of the broker, their licenses must be verified. A valid license shows that the broker is committed to acting within the rules established by the regulator.

Notable regulators around the world include:

➠ the Financial Conduct Authority (FCA) in the United Kingdom

➠ the U.S. Securities and Exchange Commission (SEC) in the United States

➠ the Australian Securities and Investments Commission (ASIC) in Australia

➠ the Cyprus Securities and Exchange Commission (CySEC) in Cyprus

➠ and others.

Typically, information regarding broker licenses can be found at the bottom of the page on the broker's website.

The above steps can minimize the risk of the broker's failure to meet its obligations to the client. To work on all the existing risks, a trader can minimize each of them independently according to this scheme.

Below, we will see how to minimize the risk of capital losses associated with the risk of price changes, which is what every trader faces when trading in the financial markets.

Types of Hedging in Trading

✔️ When answering the question "What is hedging?" many traders and investors will think of market risks. Namely, the risk of price changes "against" traders' orders, the risk of high volatility, and the risk of low liquidity.

All these risks can lead to the fact that the trader's positions will be closed mainly by stop-loss orders, or even go beyond. It is impossible to guarantee one hundred percent protection of the trader's capital against these risks, but one can try to minimize them.

Let's consider several ways:

1.      ➡️ Use the Stop Loss order. This approach involves the classic use of a stop-loss order. Namely, placing a stop-loss order in the amount that the trader is willing to lose in this position.

2.      ➡️ Use Hedging. This method consists of opening a position for a selected trading instrument in the opposite direction of the main order. The volumes of the orders must coincide for full coverage. This method will be discussed in more detail below in the "Example of Hedging in Trading" section.

By definition, there is also a "partial hedge" when a "reverse" order is opened at a size smaller than the size of the principal position.

3.      ➡️ Trading using inter-correlated instruments. This approach is similar to hedging, except that the role of the "reverse" order is played by a position in another instrument. There must be a strong relationship between the trading instruments.

4.      ➡️ Split the position into several parts. This may be relevant in the case of markets with low liquidity. In this case, the trader may face the impossibility of opening a "reverse" position at the desired size due to its large size.

Then he should try to split the position into several parts and place them on levels close to each other. Even if it does not cover the entire order, it can provide partial coverage.